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Credit rating agency

A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments,[1] and in some cases, of the servicers of the underlying debt,[2] but not of individual consumers.

The value of credit ratings for securities has been widely questioned. Hundreds of billions of securities that were given the agencies' highest ratings were downgraded to junk during the financial crisis of 2007–08.[4][5][6] Rating downgrades during the European sovereign debt crisis of 2010–12 were blamed by EU officials for accelerating the crisis.[3]

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When the United States began to expand to the west and other parts of the country, so did the distance of businesses to their customers. When businesses were close to those who purchased goods or services from them, it was easy for the merchants to extend credit to them, due to their proximity and the fact that merchants knew their customers personally and knew whether or not they would be able to pay them back. As trading distances increased, merchants no longer personally knew their customers and became leery of extending credit to people who they did not know in fear of them not being able to pay them back. Business owners' hesitation to extend credit to new customers led to the birth of the credit reporting industry.[7]

Mercantile credit agencies—the precursors of today's rating agencies—were established in the wake of the financial crisis of 1837. These agencies rated the ability of merchants to pay their debts and consolidated these ratings in published guides.[8] The first such agency was established in 1841 by Lewis Tappan in New York City.[8][9] It was subsequently acquired by Robert Dun, who published its first ratings guide in 1859. Another early agency, John Bradstreet, formed in 1849 and published a ratings guide in 1857.[8]

Credit rating agencies originated in the United States in the early 1900s, when ratings began to be applied to securities, specifically those related to the railroad bond market.[8] In the United States, the construction of extensive railroad systems had led to the development of corporate bond issues to finance them, and therefore a bond market several times larger than in other countries. The bond markets in the Netherlands and Britain had been established longer but tended to be small, and revolved around sovereign governments that were trusted to honor their debts.[10] Companies were founded to provide investors with financial information on the growing railroad industry, including Henry Varnum Poor's publishing company, which produced a publication compiling financial data about the railroad and canal industries.[11] Following the 1907 financial crisis, demand rose for such independent market information, in particular for independent analyses of bond creditworthiness.[12] In 1909, financial analyst John Moody issued a publication focused solely on railroad bonds.[12][13][14] His ratings became the first to be published widely in an accessible format,[10][12][15] and his company was the first to charge subscription fees to investors.[14]

In 1913, the ratings publication by Moody's underwent two significant changes: it expanded its focus to include industrial firms and utilities, and it began to use a letter-rating system. For the first time, public securities were rated using a system borrowed from the mercantile credit rating agencies, using letters to indicate their creditworthiness.[16] In the next few years, antecedents of the "Big Three" credit rating agencies were established. Poor's Publishing Company began issuing ratings in 1916, Standard Statistics Company in 1922,[12] and the Fitch Publishing Company in 1924.[13]

In the United States, the rating industry grew and consolidated rapidly following the passage of the Glass-Steagall act of 1933 and the separation of the securities business from banking.[17] As the market grew beyond that of traditional investment banking institutions, new investors again called for increased transparency, leading to the passage of new, mandatory disclosure laws for issuers, and the creation of the Securities and Exchange Commission (SEC).[10] In 1936, regulation was introduced to prohibit banks from investing in bonds determined by "recognized rating manuals" (the forerunners of credit rating agencies) to be "speculative investment securities" ("junk bonds", in modern terminology). US banks were permitted to hold only "investment grade" bonds, and it was the ratings of Fitch, Moody's, Poor's, and Standard that legally determined which bonds were which. State insurance regulators approved similar requirements in the following decades.[13]

From 1930 to 1980, the bonds and ratings of them were primarily relegated to American municipalities and American blue chip industrial firms.[18] International "sovereign bond" rating shrivelled during the Great Depression to a handful of the most creditworthy countries,[19] after a number of defaults of bonds issued by governments such as Germany's.[18]

In the late 1960s and 1970s, ratings were extended to commercial paper and bank deposits. Also during that time, major agencies changed their business model by beginning to charge bond issuers as well as investors.[12] The reasons for this change included a growing free rider problem related to the increasing availability of inexpensive photocopy machines[20] and the increased complexity of the financial markets.[21]

The rating agencies added levels of gradation to their rating systems. In 1973, Fitch added plus and minus symbols to its existing letter-rating system. The following year, Standard and Poor's did the same, and Moody's began using numbers for the same purpose in 1982.[8]

The end of the Bretton Woods system in 1971 led to the liberalization of financial regulations and the global expansion of capital markets in the 1970s and 1980s.[12] In 1975, SEC rules began explicitly referencing credit ratings.[22] For example, the commission changed its minimum capital requirements for broker-dealers, allowing smaller reserves for higher-rated bonds; the rating would be done by "nationally recognized statistical ratings organizations" (NRSROs). This referred to the "Big Three",[23] but in time ten agencies (later six, due to consolidation) were identified by the SEC as NRSROs.[13][24]

Rating agencies also grew in size and profitability as the number of issuers accessing the debt markets grew exponentially, both in the United States and abroad.[25] By 2009 the worldwide bond market (total debt outstanding) reached an estimated $82.2 trillion, in 2009 dollars.[26]

Two economic trends of the 1980s and 90s that brought significant expansion for the global capital market were[12]

the move away from "intermediated" financing (bank loans) toward cheaper and longer-term "disintermediated" financing (tradable bonds and other fixed income securities),[27] and

the global move away from state intervention and state-led industrial adjustment toward economic liberalism based on (among other things) global capital markets and arms-length relations between government and industry.[28]

More debt securities meant more business for the Big Three agencies, which many investors depended on to judge the securities of the capital market.[14] US government regulators also depended on the rating agencies; they allowed pension funds and money market funds to purchase only securities rated above certain levels.[29]

A market for low-rated, high-yield "junk" bonds blossomed in the late 1970s, expanding securities financing to firms other than a few large, established blue chip corporations.[28] Rating agencies also began to apply their ratings beyond bonds to counterparty risks, the performance risk of mortgage servicers, and the price volatility of mutual funds and mortgage-backed securities.[8] Ratings were increasingly used in most developed countries' financial markets and in the "emerging markets" of the developing world. Moody's and S&P opened offices Europe, Japan, and particularly emerging markets.[12] Non-American agencies also developed outside of the United States. Along with the largest US raters, one British, two Canadian and three Japanese firms were listed among the world's "most influential" rating agencies in the early 1990s by the Financial Times publication Credit Ratings International.[30]

The Big Three issued 97%–98% of all credit ratings in the United States[34] and roughly 95% worldwide,[35] giving them considerable pricing power.[36] This and credit market expansion brought them profit margins of around 50% from 2004 through 2009.[37][38]

As the influence and profitability of CRAs expanded, so did scrutiny and concern about their performance and alleged illegal practices.[39] In 1996 the US Department of Justice launched an investigation into possible improper pressuring of issuers by Moody's in order to win business.[40][41] Agencies were subjected to dozens of lawsuits by investors complaining of inaccurate ratings[42][43] following the collapse of Enron,[12] and especially after the US subprime mortgage crisis and subsequent late-2000s financial crisis.[44][45] During that debacle, 73%—over $800 billion worth[46]—of all mortgage-backed securities that one credit rating agency (Moody's) had rated triple-A in 2006 were downgraded to junk status two years later.[46][47]

Downgrades of European and US sovereign debt were also criticized. In August 2011, S&P downgraded the long-held triple-A rating of US securities.[3] Since the spring of 2010,

one or more of the Big Three relegated Greece, Portugal, and Ireland to "junk" status—a move that many EU officials say has accelerated a burgeoning European sovereign-debt crisis. In January 2012, amid continued eurozone instability, S&P downgraded nine eurozone countries, stripping France and Austria of their triple-A ratings.[3]

CRAs theoretically provide investors with an independent evaluation and assessment of debt securities' creditworthiness.[57] However, in recent decades the paying customers of CRAs have primarily not been issuers of securities but buyers, raising the issue of conflict of interest (see below).[58]

In addition, rating agencies have been liable—at least in US courts—for any losses incurred by the inaccuracy of their ratings only if it is proven that they knew the ratings were false or exhibited "reckless disregard for the truth".[12][59][60] Otherwise, ratings are simply an expression of the agencies' informed opinions,[61] protected as "free speech" under the First Amendment.[62][63] As one rating agency disclaimer read:

The ratings ... are and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell, or hold any securities.[64]

Under an amendment to the 2010 Dodd-Frank Act, this protection has been removed, but how the law will be implemented remains to be determined by rules made by the SEC and decisions by courts.[65][66][67][68]

To determine a bond's rating, a credit rating agency analyzes the accounts of the issuer and the legal agreements attached to the bond[69][70] to produce what is effectively a forecast of the bond's chance of default, expected loss, or a similar metric.[69] The metrics vary somewhat between the agencies. S&P's ratings reflect default probability, while ratings by Moody's reflect expected investor losses in the case of default.[71][72] For corporate obligations, Fitch's ratings incorporate a measure of investor loss in the event of default, but its ratings on structured, project, and public finance obligations narrowly measure default risk.[73] The process and criteria for rating a convertible bond are similar, although different enough that bonds and convertible bonds issued by the same entity may still receive different ratings.[74] Some bank loans may receive ratings to assist in wider syndication and attract institutional investors.[70]

The relative risks—the rating grades—are usually expressed through some variation of an alphabetical combination of lower- and uppercase letters, with either plus or minus signs or numbers added to further fine-tune the rating.[75][76]

Fitch and S&P use (from the most creditworthy to the least) AAA, AA, A, and BBB for investment-grade long-term credit risk and BB, CCC, CC, C, and D for "speculative" long-term credit risk. Moody's long-term designators are Aaa, Aa, A, and Baa for investment grade and Ba, B, Caa, Ca, and C for speculative grade.[75][76] Fitch and S&P use pluses and minuses (e.g., AA+ and AA-), and Moody's uses numbers (e.g., Aa1 and Aa3) to add further gradations.[75][76]

Sources: Basis spread is
between US treasuries
and rated bonds
over a 16-year period;[23][78]
Default rate over a
5-year period, from a study
by Moody's investment service[80][81]

Agencies do not attach a hard number of probability of default to each grade, preferring descriptive definitions, such as "the obligor's capacity to meet its financial commitment on the obligation is extremely strong," (from a Standard and Poor's definition of a AAA-rated bond) or "less vulnerable to non-payment than other speculative issues" (for a BB-rated bond).[82] However, some studies have estimated the average risk and reward of bonds by rating. One study by Moody's[80][81] claimed that over a "5-year time horizon", bonds that were given its highest rating (Aaa) had a "cumulative default rate" of just 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2). (See "Default rate" in "Estimated spreads and default rates by rating grade" table to right.) Over a longer time horizon, it stated, "the order is by and large, but not exactly, preserved".[83]

Another study in the Journal of Finance calculated the additional interest rate or "spread" that corporate bonds pay over that of "riskless" US Treasury bonds, according to the bonds rating. (See "Basis point spread" in the table to right.) Looking at rated bonds from 1973 through 1989, the authors found a AAA-rated bond paid only 43 "basis points" (or 43/100ths of a percentage point) more than a Treasury bond (so that it would yield 3.43% if the Treasury bond yielded 3.00%). A CCC-rated "junk" (or speculative) bond, on the other hand, paid over 4% more than a Treasury bond on average (7.04% if the Treasury bond yielded 3.00%) over that period.[23][78]

The market also follows the benefits from ratings that result from government regulations (see below), which often prohibit financial institutions from purchasing securities rated below a certain level. For example, in the United States, in accordance with two 1989 regulations, pension funds are prohibited from investing in asset-backed securities rated below A,[84] and savings and loan associations from investing in securities rated below BBB.[85]

CRAs provide "surveillance" (ongoing review of securities after their initial rating) and may change a security's rating if they feel its creditworthiness has changed. CRAs typically signal in advance their intention to consider rating changes.[75][86] Fitch, Moody's, and S&P all use negative "outlook" notifications to indicate the potential for a downgrade within the next two years (one year in the case of speculative-grade credits). Negative "watch" notifications are used to indicate that a downgrade is likely within the next 90 days.[75][86]

In the 2001 Enron accounting scandal, the company's ratings remained at investment grade until four days before bankruptcy—though Enron's stock had been in sharp decline for several months[92][93]—when "the outlines of its fraudulent practices" were first revealed.[94] Critics complained that "not a single analyst at either Moody's of S&P lost his job as a result of missing the Enron fraud" and "management stayed the same".[95] During the subprime crisis, when hundreds of billion of dollars' worth[46] of triple-A-rated mortgage-backed securities were abruptly downgraded from triple-A to "junk" status within two years of issue,[47] the CRAs' ratings were characterized by critics as "catastrophically misleading"[96] and "provided little or no value".[66][97] Ratings of preferred stocks also fared poorly. Despite over a year of rising mortgage deliquencies,[98] Moody's continued to rate Freddie Mac's preferred stock triple-A until mid-2008, when it was downgraded to one tick above the junk bond level.[99][100] Some empirical studies have also found that rather than a downgrade lowering the market price and raising the interest rates of corporate bonds, the cause and effect are reversed. Expanding yield spreads (i.e., declining value and quality) of corporate bonds precedes downgrades by agencies, suggesting it is the market that alerts the CRAs of trouble and not vice versa.[101][102]

In response, defenders of credit rating agencies complain of the market's lack of appreciation. Argues Robert Clow, "When a company or sovereign nation pays its debt on time, the market barely takes momentary notice ... but let a country or corporation unexpectedly miss a payment or threaten default, and bondholders, lawyers and even regulators are quick to rush the field to protest the credit analyst's lapse."[103] Others say that bonds assigned a low credit rating by rating agencies have been shown to default more frequently than bonds that receive a high credit rating, suggesting that ratings still serve as a useful indicator of credit risk.[65]

A number of explanations of the rating agencies' inaccurate ratings and forecasts have been offered, especially in the wake of the subprime crisis:[89][91]

The methodologies employed by agencies to rate and monitor securities may be inherently flawed.[104] For instance, a 2008 report by the Financial Stability Forum singled out methodological shortcomings—especially inadequate historical data—as a contributing cause in the underestimating of the risk in structured finance products by the CRAs before the subprime mortgage crisis.[105]

The ratings process relies on subjective judgments. This means that governments, for example, that are being rated can often inform and influence credit rating analysts during the review process[106]

The rating agencies' interest in pleasing the issuers of securities, who are their paying customers and benefit from high ratings, creates a conflict with their interest in providing accurate ratings of securities for investors buying the securities.[107] Issuers of securities benefit from higher ratings in that many of their customers—retail banks, pension funds, money market funds, insurance companies—are prohibited by law or otherwise restrained from buying securities below a certain rating.[85]

The rating agencies may have been significantly understaffed during the subprime boom and thus unable to properly assess every debt instrument.[108]

Agency analysts may be underpaid relative to similar positions at investment banks and Wall Street firms, resulting in a migration of credit rating analysts and the analysts' inside knowledge of rating procedures to higher-paying jobs at the banks and firms that issue the securities being rated, and thereby facilitating the manipulation of ratings by issuers.[100]

The functional use of ratings as regulatory mechanisms may inflate their reputation for accuracy.[109]

Conversely, the complaint has been made that agencies have too much power over issuers and that downgrades can even force troubled companies into bankruptcy. The lowering of a credit score by a CRA can create a vicious cycle and a self-fulfilling prophecy: not only do interest rates on securities rise, but other contracts with financial institutions may also be affected adversely, causing an increase in financing costs and an ensuing decrease in creditworthiness. Large loans to companies often contain a clause that makes the loan due in full if the company's credit rating is lowered beyond a certain point (usually from investment grade to "speculative"). The purpose of these "ratings triggers" is to ensure that the loan-making bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; if the company is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called death spiral). These ratings triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting them and discouraging their use, and the US SEC requires that public companies in the United States disclose their existence.

The 2010 Dodd–Frank Wall Street Reform and Consumer Protection Act[110] mandated improvements to the regulation of credit rating agencies and addressed several issues relating to the accuracy of credit ratings specifically.[65][68] Under Dodd-Frank rules, agencies must publicly disclose how their ratings have performed over time and must provide additional information in their analyses so investors can make better decisions.[65][68] An amendment to the act also specifies that ratings are not protected by the First Amendment as free speech but are "fundamentally commercial in character and should be subject to the same standards of liability and oversight as apply to auditors, securities analysts and investment bankers."[66][65] Implementation of this amendment has proven difficult due to conflict between the SEC and the rating agencies.[68][67] The Economist magazine credits the free speech defence at least in part for the fact that "41 legal actions targeting S&P have been dropped or dismissed" since the crisis.[111]

In the European Union, there is no specific legislation governing contracts between issuers and credit rating agencies.[67] General rules of contract law apply in full, although it is difficult to hold agencies liable for breach of contract.[67] In 2012, an Australian federal court held Standard & Poor's liable for inaccurate ratings.[67]

Credit ratings for structured finance instruments may be distinguished from ratings for other debt securities in several important ways.[113]

These securities are more complex and an accurate prognoses of repayment more difficult than with other debt ratings.[113][114] This is because they are formed by pooling debt — usually consumer credit assets, such as mortgages, credit card or auto loans — and structured by "slicing" the pool into multiple "tranches", each with a different priority of payment. Tranches are often likened to buckets capturing cascading water, where the water of monthly or quarterly repayment flows down to the next bucket (tranche) only if the one above has been filled with its full share and is overflowing. The higher-up the bucket in the income stream, the lower its risk, the higher its credit rating, and lower its interest payment.[115] This means the higher-level tranches have more credit worthiness than would a conventional unstructured, untranched bond with the same repayment income stream, and allows rating agencies to rate the tranches triple A or other high grades. Such securities are then eligible for purchase by pension funds and money market funds restricted to higher-rated debt, and for use by banks wanting to reduce costly capital requirements.[116][117][118]

CRAs are not only paid for giving ratings to structured securities, but may be paid for advice on how to structure tranches[113][119] and sometimes the underlying assets that secure the debt[119][120] to achieve ratings the issuer desires. This involves back and forth interaction and analysis between the sponsor of the trust that issues the security and the rating agency.[113][119] During this process, the sponsor may submit proposed structures to the agency for analysis and feedback until the sponsor is satisfied with the ratings of the different tranches.[119][120]

Credit rating agencies employ varying methodologies to rate structured finance products, but generally focus on the type of pool of financial assets underlying the security and the proposed capital structure of the trust.[119] This approach often involves a quantitative assessment in accordance with mathematical models, and may thus introduce a degree of model risk.[113][121] However, bank models of risk assessment have proven less reliable than credit rating agency models, even in the base of large banks with sophisticated risk management procedures.[122]

Aside from investors mentioned above—who are subject to ratings-based constraints in buying securities—some investors simply prefer that a structured finance product be rated by a credit rating agency.[119] And not all structured finance products receive a credit rating agency rating.[119] Ratings for complicated or risky CDOs are unusual and some issuers create structured products relying solely on internal analytics to assess credit risk.[119]

Credit rating agencies began issuing ratings for mortgage-backed securities (MBS) in the mid-1970s. In subsequent years, the ratings were applied to securities backed by other types of assets.[119] During the first years of the twenty-first century, demand for highly rated fixed income securities was high.[125] Growth was particularly strong and profitable in the structured finance industry during the 2001-2006 subprime mortgage boom, and business with finance industry accounted for almost all of the revenue growth at at least one of the CRAs (Moody's).[126]

From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities as triple-A. In contrast only six (private sector) companies in the United States were given that top rating.[127]

Rating agencies were even more important in rating collateralized debt obligations (CDOs). These securities mortgage/asset backed security tranches lower in the "waterfall" of repayment that could not be rated triple-A, but for whom buyers had to found or the rest of the pool of mortgages and other assets could not be securitized. Rating agencies solved the problem by rating 70%[128] to 80%[129] of the CDO tranches triple-A. Still another innovative structured product most of whose tranches were also given high ratings was the "synthetic CDO". Cheaper and easier to create than ordinary "cash" CDOs, they paid insurance premium-like payments from credit default swap "insurance", instead of interest and principal payments from house mortgages. If the insured or "referenced" CDOs defaulted, investors lost their investment, which was paid out much like an insurance claim.[130]

However when it was discovered that the mortgages had been sold to buyers who could not pay them, massive numbers of securities were downgraded, the securitization "seized up" and the Great Recession ensued.[131][132]

Critics blamed this underestimation of the risk of the securities on the conflict between two interests the CRAs have—rating securities accurately, and serving their customers, the security issuers[133] who need high ratings to sell to investors subject to ratings-based constraints, such as pension funds and life insurance companies.[117][118] While this conflict had existed for years, the combination of CRA focus on market share and earnings growth,[134] the importance of structured finance to CRA profits,[135] and pressure from issuers who began to `shop around` for the best ratings brought the conflict to a head between 2000 and 2007.[136][137][138][139]

A small number of arrangers of structured finance products—primarily investment banks—drive a large amount of business to the ratings agencies, and thus have a much greater potential to exert undue influence on a rating agency than a single corporate debt issuer.[140]

A 2013 Swiss Finance Institute study of structured debt ratings from S&P, Moody's, and Fitch found that agencies provide better ratings for the structured products of issuers that provide them with more overall bilateral rating business.[141][142] This effect was found to be particularly pronounced in the run-up to the subprime mortgage crisis.[141][142] Alternative accounts of the agencies' inaccurate ratings before the crisis downplay the conflict of interest factor and focus instead on the agencies' overconfidence in rating securities, which stemmed from faith in their methodologies and past successes with subprime securitizations.[143][144]

In the wake of the global financial crisis, various legal requirements were introduced to increase the transparency of structured finance ratings. The European Union now requires credit rating agencies to use an additional symbol with ratings for structured finance instruments in order to distinguish them from other rating categories.[113]

Credit rating agencies also issue credit ratings for sovereign borrowers, including national governments, states, municipalities, and sovereign-supported international entities.[145] Sovereign borrowers are the largest debt borrowers in many financial markets.[145] Governments from both advanced economies and emerging markets borrow money by issuing government bonds and selling them to private investors, either overseas or domestically.[146] Governments from emerging and developing markets may also choose to borrow from other governments and international organizations, such as the World Bank and the International Monetary Fund.[146]

Sovereign credit ratings represent an assessment by a rating agency of a sovereign's ability and willingness to repay its debt.[147] The rating methodologies used to assess sovereign credit ratings are broadly similar to those used for corporate credit ratings, although the borrower's willingness to repay receives extra emphasis since national governments may be eligible for debt immunity under international law, thus complicating repayment obligations.[145][146] In addition, credit assessments reflect not only the long-term perceived default risk, but also short- or immediate-term political and economic developments.[148] Differences in sovereign ratings between agencies may reflect varying qualitative evaluations of the investment environment.[149]

National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets.[148][149] Developing countries often depend on strong sovereign credit ratings to access funding in international bond markets.[148] Once ratings for a sovereign have been initiated, the rating agency will continue to monitor for relevant developments and adjust its credit opinion accordingly.[148]

A 2010 International Monetary Fund study concluded that ratings were a reasonably good indicator of sovereign-default risk.[51][150] However, credit rating agencies were criticized for failing to predict the 1997 Asian financial crisis and for downgrading countries in the midst of that turmoil.[147] Similar criticisms emerged after recent credit downgrades to Greece, Ireland, Portugal, and Spain,[147] although credit ratings agencies had begun to downgrade peripheral Eurozone countries well before the Eurozone crisis began.[150]

As part of the Sarbanes–Oxley Act of 2002, Congress ordered the U.S. SEC to develop a report, titled "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets"[151] detailing how credit ratings are used in U.S. regulation and the policy issues this use raises. Partly as a result of this report, in June 2003, the SEC published a "concept release" called "Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws"[152] that sought public comment on many of the issues raised in its report. Public comments on this concept release have also been published on the SEC's website.[153]

In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct[154] for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the US SEC.

Regulatory authorities and legislative bodies in the United States and other jurisdictions rely on credit rating agencies' assessments of a broad range of debt issuers, and thereby attach a regulatory function to their ratings.[155][156] This regulatory role is a derivative function in that the agencies do not publish ratings for that purpose.[155] Governing bodies at both the national and international level have woven credit ratings into minimum capital requirements for banks, allowable investment alternatives for many institutional investors, and similar restrictive regulations for insurance companies and other financial market participants.[157][158]

The extensive use of credit ratings for regulatory purposes can have a number of unintended effects.[155] Because regulated market participants must follow minimum investment grade provisions, ratings changes across the investment/non-investment grade boundary may lead to strong market price fluctuations and potentially cause systemic reactions.[155] The regulatory function granted to credit rating agencies may also adversely affect their original market information function of providing credit opinions.[155][162]

Against this background and in the wake of criticism of credit rating agencies following the subprime mortgage crisis, legislators in the United States and other jurisdictions have commenced to reduce rating reliance in laws and regulations.[89][163] The 2010 Dodd–Frank Act removes statutory references to credit rating agencies, and calls for federal regulators to review and modify existing regulations to avoid relying on credit ratings as the sole assessment of creditworthiness.[164][165][166]

As of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors;[167][169] Moody's has 1 million outstanding ratings and 1,252 analysts and supervisors;[167][169] and Fitch is the smallest, with approximately 350,000 outstanding ratings, and is sometimes used as an alternative to S&P and Moody’s.[167][170]

The three largest agencies are not the only sources of credit information.[54] Many smaller rating agencies also exist, mostly serving non-US markets.[171] All of the large securities firms have internal fixed income analysts who offer information about the risk and volatility of securities to their clients.[54] And specialized risk consultants working in a variety of fields offer credit models and default estimates.[54]

Market share concentration is not a new development in the credit rating industry. Since the establishment of the first agency in 1909, there have never been more than four credit rating agencies with significant market share.[172] Even the Financial crisis of 2007–08—where the performance of the three rating agencies was dubbed "horrendous" by The Economist magazine[173]—led to a drop in the share of the three by just one percent—from 98 to 97%.[174]

The reason for the concentrated market structure is disputed. One widely cited opinion is that the Big Three's historical reputation within the financial industry creates a high barrier of entry for new entrants.[172] Following the enactment of the Credit Rating Agency Reform Act of 2006 in the US, seven additional rating agencies attained recognition from the SEC as nationally recognized statistical rating organization (NRSROs).[175][176] While these other agencies remain niche players,[177] some have gained market share following the Financial crisis of 2007–08,[178] and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group.[179] The European Union has considered setting up a state-supported EU-based agency.[180] In November 2013, credit ratings organizations from five countries (CPR of Portugal, CARE Rating of India, GCR of South Africa, MARC of Malaysia, and SR Rating of Brazil) joint ventured to launch ARC Ratings, a new global agency touted as an alternative to the "Big Three".[181]

Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings.[187] The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer-pays model.[49] However, agencies may offer additional services using a combination of business models.[187][188]

Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings.[49][189] This revenue provides the main source of agency income, although agencies may also provide other types of services.[49][190] Under the issuer-pays model, agencies charge issuers a fee for providing credit rating assessments.[49] This revenue stream allows issuer-pays credit rating agencies to make their ratings freely available to the broader market, especially via the Internet.[191][192]

Critics argue that the issuer-pays model creates a potential conflict of interest because the agencies are paid by the organizations whose debt they rate.[197] However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors.[191][192] Issuer-pays CRAs have argued that subscription-models can also be subject to conflicts of interest due to pressures from investors with strong preferences on product ratings.[198] In 2010 Lace Financials, a subscriber-pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber.[199]

A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber-based third parties.[200] Other proposed alternatives include a "public-sector" model in which national governments fund the rating costs, and an "exchange-pays" model, in which stock and bond exchanges pay for the ratings.[201][202] Crowd-sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer-pays models, although it is a recent development as of the 2010, and not yet widely used.[203][204]

Agencies are sometimes accused of being oligopolists,[205] because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.[206]

Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry.[209] Celebrated investor Warren Buffett described the company as “a natural duopoly,” with “incredible” pricing power, when asked by the Financial Crisis Inquiry Commission about his ownership of 15% of the company.[210][211]

According to professor Frank Partnoy, the regulation of CRAs by the SEC and Federal Reserve Bank has eliminated competition between CRAs and practically forced market participants to use the services of the three big agencies, Standard and Poor's, Moody's and Fitch.[212]

SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions. When the CRAs gave ratings that were "catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."[212]

To solve this problem, Ms. Casey (and others such as NYU professor Lawrence White[213]) have proposed removing the NRSRO rules completely.[212] Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.[212]

The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.[213]

^A debt instrument is any type of documented financial obligation. A debt instrument makes it possible to transfer the ownership of debt so it can be traded. (source: wisegeek.com)

^For example, in the US, a state government which shares the credit responsibility for a Municipal bond issued by a municipal government entities but under the control of that state government entity. (source:Campbell R. Harvey's Hypertextual Finance Glossary)

^$300 billion collateralized debt obligations (CDOs) issued in 2005-2007 (over half of the CDOs by value during time period) that rating agencies gave their highest "triple-A" rating to, were written-down to "junk" by the end of 2009. (source: The Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. pp. 228–9.)

^ abcCantor, Richard; Packer, Frank (Summer–Fall 1994). "The credit rating industry"(PDF). Federal Reserve Bank of New York Quarterly Review. Federal Reserve Bank of New York. p. 8. ISSN0147-6580. Archived from the original(PDF) on 2011-04-29. When the phrase NRSRO was first used, the SEC was referring to the three agencies that had a national presence at that time, Moody's, Standard and Poor's and Fitch.

^Outstanding World Bond Market Debt from the Bank for International Settlements via Asset Allocation Advisor. Original BIS data as of March 31, 2009; Asset Allocation Advisor compilation as of November 15, 2009. Accessed January 7, 2010.

^Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press. pp. 54–56. ISBN978-0801474910. Retrieved 21 September 2013. Changes in the financial markets have made people think the agencies are increasingly important. ... What is disintermediation? Banks acted as financial intermediaries in that they brought together suppliers and users of funds. ... Disintermediation has occurred on both sides of the balance sheet. Mutual funds ... now contain $2 trillion in assets – not much less than the $2.7 trillion held in U.S. bank deposits. ... In 1970, commercial lending by banks made up 65% of the borrowing needs of corporate America. By 1992, the banks' share had fallen to 36%

^Financial Crisis Inquiry Report(PDF). GPO. 2011. p. 119. Credit ratings also determined whether investors could buy certain investments at all. The SEC restricts money market funds to purchasing “securities that have received credit ratings from any two NRSROs ... in one of the two highest short-term rating categories or comparable unrated securities.” The Department of Labor restricts pension fund investments to securities rated A or higher. Credit ratings affect even private transactions: contracts may contain triggers that require the posting of collateral or immediate repayment, should a security or entity be downgraded. Triggers played an important role in the financial crisis and helped cripple AIG.

^ abThe Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. pp. 43–44. Purchasers of the safer tranches got a higher rate of return than ultra-safe Treasury notes without much extra risk—at least in theory. However, the financial engineering behind these investments made them harder to understand and to price than individual loans. To determine likely returns, investors had to calculate the statistical probabilities that certain kinds of mortgages might default, and to estimate the revenues that would be lost because of those defaults. Then investors had to determine the effect of the losses on the payments to different tranches. This complexity transformed the three leading credit rating agencies—Moody’s, Standard & Poor’s (S&P), and Fitch—into key players in the process, positioned between the issuers and the investors of securities.

^Alessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. Retrieved 29 May 2013. By 2006, Moodys' had earned more revenue from structured finance – $881 million – than all its business revenues combined for 2001

^Status quo for rating agencies (chart of percentage of outstanding credit ratings reported to the SEC 2007 and 2011; and Moody's revenue and income 1996, 2000, 2010, 2012)| mcclatchydc.com

^Alessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. `The three major rating agencies hold a collective market share of roughly 95%. Their special status has been cemented by law – at first only in the United States, but then in Europe as well,` explains an analysis by DeutscheWelle.

^Evans, David; Caroline Salas (April 29, 2009). "Flawed Credit Ratings Reap Profits as Regulators Fail (Update1)". Bloomberg. Archived from the original on October 17, 2015. S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says SEC Commissioner Casey, 43, appointed by President George W. Bush in July 2006 to a five-year term. S&P, a unit of McGraw-Hill Cos., has profit margins similar to those at Moody’s, she says. `They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators,` Casey says.

^Evans, David; Caroline Salas (April 29, 2009). "Flawed Credit Ratings Reap Profits as Regulators Fail (Update1)". Bloomberg. Archived from the original on October 17, 2015. Moody’s, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 percent over the past five years. It reported revenue of $1.76 billion – earning a pretax margin of 41 percent – even during the economic collapse in 2008. S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says SEC Commissioner Casey, 43, appointed by President George W. Bush in July 2006 to a five-year term. S&P, a unit of McGraw-Hill Cos., has profit margins similar to those at Moody’s, she says.

^Younglai, Rachelle; daCosta, Ana (2 August 2011). "Insight: When ratings agencies judge the world". Reuters. Retrieved 20 September 2013. Critics say this created perverse incentives such that at the height of the credit boom in 2005 to 2007, the agencies recklessly awarded Triple A ratings to complex exotic structured instruments that they scarcely understood. They have profited handsomely. In the three-year period ending in 2007, the height of the credit boom, S&P's operating profit rose 73 percent to $3.58 billion compared to the three-year period ending in 2004. The comparable gain for Moody's over the same period was 68 percent to $3.33 billion.

^ abcAlessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. Retrieved 29 May 2013. In 2007, as housing prices began to tumble, Moody's downgraded 83% of the $869 billion in mortgage securities it had rated at the AAA level in 2006

^ abThe Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 122. Retrieved 5 November 2013. In October 2007, the M4-M11 tranches [on one subprime mortgage backed deal the FCIC followed] were downgraded and by 2008, all the tranches were downgraded. Of all mortgage-backed securities it rated triple-A in 2006, Moody's downgraded 73% to junk.

^McLean, Bethany; Joe Nocera (2010). All the Devils Are Here: The Hidden History of the Financial Crisis. Portfolio Penguin. pp. 112–117. ISBN1591843634.

^Global Financial Stability Report Chapter 3: The Uses and Abuses of Sovereign Credit Ratings(pdf). International Monetary Fund. October 2010. p. 2. According to the theoretical literature, CRAs potentially provide information, monitoring, and certification services. First, since investors do not often know as much as issuers about the factors that determine credit quality, credit ratings address an important problem of asymmetric information between debt issuers and investors. Hence, CRAs provide an independent evaluation and assessment of the ability of issuers to meet their debt obligations. In this way, CRAs provide `information services` that reduce information costs, increase the pool of potential borrowers, and promote liquid markets.

^"CREDIT AGENCY REFORM ACT of 2006"(PDF). October 27, 2006. CAHILL GORDON & REINDEL LLP. Archived from the original(PDF) on 14 December 2013. Retrieved 30 November 2013. These courts have held, among other things, that rating agencies are protected by the “actual malice” standard, which insulates them from liability for their ratings unless the publications are made with “knowledge of falsity” or “reckless disregard for the truth.”

^"Credit and blame". The Economist. 6 September 2007. It is very hard to see how this combination can be justified. Imagine if patients were forced to use doctors whose incomes depended on the pharmaceutical companies, but who were immune from lawsuits if they prescribed a toxic drug.

^ abMcLean, Bethany; Joe Nocera (2010). All the Devils Are Here. Portfolio Penguin. pp. 113–114. The agencies had charts and studies showing that their ratings were accurate a very high percentage of the time. But anyone who dig more deeply could find many instances when they got it wrong, usually when something unexpected happened. The rating agencies had missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970s and Long-Term Capital Management in the 1990s. They often downgraded companies just days before bankruptcy – too late to help investors. Nor was this anything new: one study showed that 78% of the municipal bonds rated double A or triple-A in 1929 defaulted during the Great Depression.

^Bethany McLean; Joe Nocera (2010). All the Devils Are Here, the Hidden History of the Financial Crisis. Portfolio Penguin. pp. 113–114. ISBN1591843634.

^Bethany McLean; Joe Nocera (2010). All the Devils Are Here: The Hidden History of the Financial Crisis. Portfolio Penguin. p. 120. ISBN1591843634. "Not a single analyst at either Moody's of S&P lost his job as a result of missing the Enron fraud. Management stayed the same. Moody's stock price, after a brief tumble, began rising again .... `Enron taught them how small the consequences of a bad reputation were.`

^set up by the US Congress and President to investigate the causes of the crisis, and publisher of the Financial Crisis Inquiry Report (FCIR)

^The Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 44. Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings. “The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business. ... They were looking for an independent party to develop an opinion,” Jim Callahan told the FCIC; Callahan is CEO of PentAlpha, which services the securitization industry, and years ago he worked on some of the earliest securitizations

^"Giant Pool of Money (transcript)". Originally aired 05.09.2008. This American Life (radio program) from WBEZ. Retrieved 3 September 2013. Adam Davidson: And by the way, before you finance enthusiasts start writing any letters, we do know that $70 trillion technically refers to that subset of global savings called fixed income securities. ... Ceyla Pazarbasioglu: This number doubled since 2000. In 2000 this was about $36 trillion. Adam Davidson: So it took several hundred years for the world to get to $36 trillion. And then it took six years to get another $36 trillion.

^In the case of the one CRA that was a separate public company – Moody's – "Between the time it was spun off into a public company and February 2007, its stock had risen 340%. Structured finance was approaching 50% of Moody's revenue – up from 28% in 1998. It accounted for pretty much all of Moody's growth."|McLean and Nocera, All the Devils Are Here, 2010 (p.124)

^70%. "Firms bought mortgage-backed bonds with the very highest yields they could find and reassembled them into new CDOs. The original bonds ... could be lower-rated securities that once reassembled into a new CDO would wind up with as much as 70% of the tranches rated triple-A. Ratings arbitrage, Wall Street called this practice. A more accurate term would have been ratings laundering." (source: McLean and Nocera, All the Devils Are Here, 2010 p.122)

^80%. "In a CDO you gathered a 100 different mortgage bonds — usually the riskiest lower floors of the original tower ...... They bear a lower credit rating triple B. ... if you could somehow get them rerated as triple A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. it was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: the rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80% of the new tower of debt triple-A." (source: Michael Lewis, The Big Short : Inside the Doomsday Machine WW Norton and Co, 2010, p.73)

^"Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed securities ... in the place of real mortgage assets, these CDOs contained credit default swaps and did not finance a single home purchase." (source: The Financial Crisis Inquiry Report, 2011, p.142)

^McLean, Bethany; Nocera, Joe (2010). All the Devils Are Here. Portfolio, Penguin. pp. 114–5. What caused Moody's to change were three things. ... the inexorable rise of structured finance, and the concomitant rise of Moody's structured products business. ... the 2000 spin-off, which resulted in many Moody's executives getting stock options and gave them a new appreciation for generating revenues and profits.

^McLean, Bethany; Nocera, Joe (2010). All the Devils Are Here. Portfolio, Penguin. p. 124. Between the time it was spun off into a public company and February 2007, [Moody's] stock had risen 340%. Structured finance was approaching 50% of Moody's revenue – up from 28% in 1998. It accounted for pretty much all of Moody's growth.

^The Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. pp. xxv. The three credit rating agencies were key enableers of the financial meltdown ... forces at work ... includ[e] flawed computer models, the pressure from financial firms that paid for that ratings, the relentless drive for market share, ...)

^McLean, Bethany; Nocera, Joe (2010). All the Devils Are Here. Penguin. p. 118. ISBN9781101551059. Retrieved June 5, 2014. [Example from page 118] "UBS banker Robert Morelli, upon hearing that S&P might be revising its RMSBS ratings, sent an e-mail to an S&P analyst. 'Heard your ratings could be 5 notches back of moddys [sic] equivalent, Gonna kill you resi biz. May force us to do moddyfitch only ...'"

^The Financial Crisis Inquiry Report(PDF). National Commission on the Causes of the Financial and Economic Crisis in the United States. 2011. p. 210. [When asked if the investment banks frequently threatened to withdraw their business if they didn’t get their desired rating, former Moody team managing director Gary Witt told the FCIC] Oh God, are you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of the time... It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P.’

^In the 12 months that ended in June 2011, the SEC reported that the big three issued 97% of all credit ratings, down only 1% from 98% in 2007. (sources: Gordon, Greg (August 7, 2013). "Industry wrote provision that undercuts credit-rating overhaul". McClatchy. Retrieved 4 September 2013. ; Status quo for rating agencies (chart of percentage of outstanding credit ratings reported to the SEC 2007 and 2011; and Moody's revenue and income 1996, 2000, 2010, 2012)| mcclatchydc.com

^Buffett explained that pricing power was what was important in his purchase of Moody's stock. `... he knew nothing about the management of Moody's. “I had no idea. I'd never been at Moody's, I don’t know where they are located.”` (source: The Financial Crisis Inquiry Report)

Analysts and ratings = chapter 14 in Stocks and Exchange – the only Book you need, Ladis Konecny, 2013, ISBN9783848220656.

For an historical account of the interaction between a government and the rating agencies, see David James Gill, "Rating the UK: the British government's sovereign credit ratings, 1976–78," Economic History Review, Vol. 68, No. 3 (2015), pp. 1016–1037.